Moody's Stabs S&P in the Back With a Near-Junk Rating

Now that rating agencies are starting to doubt the viability of their peers as lawsuits on pre-financial crisis ratings move forward, the time of reckoning has come.

Late on Valentine's Day, Moody's sharply cut the ratings of competitor Standard & Poor's (owned by McGraw-Hill Cos.). It cited the company's increasing legal risks now that the Department of Justice is suing Standard & Poor's on fraud charges and state attorneys general including Eric Schneiderman of New York appear to be ready to dig in for a legal fight.

Still, Moody's higher-ups aren't likely to admit it's in the same boat. The firm, after all, gave off-the-mark ratings to many of the real estate and structured securities at the heart of S&P's legal woes.

Such is life in the rating agency business, where some bullish investors and analysts expect federal and civil litigation to blow over, while others such as famed short seller David Einhorn may still have large bets on their eventual demise.

In Moody's downgrade of competitor McGraw-Hill, the agency cites the company's S&P unit and litigation tied to the DoJ's lawsuit from earlier in February. Moody's also notes an earnings-draining sale of McGraw-Hill's education business to private equity firm Apollo Global Management.

"The downgrade reflects the loss of earnings and business diversity that will result from the expected completion of the $2.5 billion sale of McGraw-Hill Education (MHE) to investment funds managed by affiliates of Apollo Global Management LLC (Apollo) as well as heightened litigation risks in light of the recent civil lawsuits filed against McGraw-Hill and its subsidiary Standard & Poor's Financial Services LLC (S&P) by the Department of Justice (DOJ) and various state attorneys general," Moody's writes.

Moody's new rating, Baa2, puts its competitor just two notches above a junk-bond rating and "balances the company's history of prevailing in its legal defenses against the potentially substantial negative credit effects that could result from adverse litigation or settlement outcomes," Moody's said.

Of particular concern, according to Moody's, is McGraw-Hill's 10 percent increase to its quarterly dividend in January and indications that cash returns to shareholders won't change despite the company's lower post-sale earnings streams. During a year-end surge to pay special dividends, McGraw-Hill also laid out a $2.50-a-share special dividend in the wake of the education unit sale to Apollo Global.

Moody's may simply be throwing stones from a glass house.

According to Mark Palmer, a financials analyst at BTIG, Moody's rising cash returns to shareholders and heightened legal risks pose a dangerous cocktail for investors. He holds out a 'sell' rating on the company's shares.

"We also think the [Moody's] analysts might want to ask their own leaders whether it made sense for the company to earmark about 95 percent of its cash for share buybacks given the distinct possibility that it may face lawsuits mirroring those filed against MHP, and that such lawsuits could have substantial negative implications for MCO's credit profile," Palmer wrote in a note to clients Friday.

Palmer said a $1 billion increase in Moody's buyback authorization may be mistimed, given it could deplete the agency's cash as a flurry of private lawsuits hits courtrooms this spring.

Even Moody's largest shareholder, Warren Buffett of Berkshire Hathaway, appears to be concerned. While Buffett said on a CNBC interview that he hasn't changed a 13 percent-plus stake in the agency, he is tracking the new legal woes of the ratings business.

Given McGraw-Hill's insistence on maintaining a large dividend and Moody's increasing buyback abilities, Palmer thinks ratings agencies are being too cavalier about their capital. The prospect of a circular set of downgrades by competitors indicates agencies themselves may be concerned.

"The sooner the rating agencies acknowledge the legal threat they face, the better off they will be for preparing for all potential outcome," Palmer said in an interview Wednesday.